Build America Bonds front-loaded issuance will lead to calmer muni market over time.

Dec. 13, 2010 8:55 PM ET

New fears and misperceptions are rattling the municipal bond market, but instead of heading for the exits, investors might be better off just buckling in for a near-term bumpy ride.

While muni bond yields have been rising in predictable stride with the recent sell-off in Treasury bonds, the muni market is also navigating the likely expiration of the Build America Bonds program as part of the latest tax package.

The wildly popular BAB program, introduced in April 2009 as taxable and federally-subsidized municipal debt, is now on the chopping block.

The BAB program, which has absorbed more than $170 billion worth of debt issuance since inception, was originally designed to expire Dec. 31, but there were efforts by the Obama Administration to extend it or even make it permanent.

Although it is possible the BAB program could be extended, or even reintroduced at a later date, the muni market has been reacting as if BAB are certain to go the way of the white tennis ball.

There has been a flood of BAB issuance over the past few months as municipalities scramble to take advantage of the program that has the federal government chipping in 35% of the interest payments.

Of the $110 billion worth of BAB issuance so far this year through the third week of November, $26 billion was issued between Oct. 1 and Nov. 26, representing a front-loading affect that is confusing the muni bond market.

The relatively concentrated issuance could represent a short-term in the BAB market as yields spike.

Even though BABs are municipal bonds, they trade more like corporate bonds because the primary buyers are tax-exempt pension funds and other institutional investors that don’t invest in tax-exempt muni bonds.

Meanwhile, for traditional retail investors of tax-exempt muni bonds, the BAB turmoil is just adding to the confusion.

One theory is that if the BAB program goes away, the traditional muni bond market would be flooded with new issuance, driving up yields and driving down values of existing bonds.

Such a scenario doesn’t sit well with investors already overwhelmed with state and local government fiscal horror stories.

The combination of fundamental and technical challenges could lead to a volatile next few months for muni bonds.

In terms of the increased emphasis on risk in the muni bond space, keep in mind that default rates are still well below 1% and that there are safeguards in place that make honoring municipal debt one of the highest priorities in most jurisdictions.

Investors should also find some comfort in the way the so-called institutional smart money has been buying up BABs over the past two years, representing 21% of all muni bond issuance.

And, finally, there is the supply-and-demand reality that the heavy BAB issuance over the past few months actually represented debt that might have otherwise been issued next year.

Thus, even if the BABs program is extended, total muni bond issuance is likely to be lower, not higher, next year.

And regardless of whether the BAB program is extended, the municipalities can only justify so much interest on debt to finance infrastructure projects. Because as those yields are pushed higher, the costs of the projects become more expensive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.